Lecture 29

LESSON - 29 Inflation - 1 Learning outcomes After studying this unit, you should be able to: Define Inflation Know different types of Inflation Distinguish between perfect competition, monopoly, and monopolistic competition Relate various theories of Inflation Know Inflationary Gap INTRODUCTION: Inflation is a highly controversial term which has undergone modification since' II was first defined by the neo-classical economists. They meant by it a galloping rise in prices as it result of the excessive increase in the quantity of money. They regarded inflation "as a destroying disease born out of lack of monetary control whose results undermined the rules of business, creating havoc in markets and financial ruin of even the prudent."1 But Keynes in his General Theory allayed all such fears. He did not believe like the neoclassicists that there was always full employment in the economy which resulted in hyper-inflation with increases in the quantity of money. According to him, there being underemployment in the economy, an increase in the money supply leads to increase in aggregate demand, output and employment. Starting from a depression, as the money supply increases, output at first rises proportionately. But as aggregate demand, output and employment rise further, diminishing returns start and certain bottlenecks appear and prices start rising; This process continues till the full employment level is reached. The rise in the price level during this period is known as bottleneck inflation or "semi inflation". If the money supply increases beyond the full employment level, output ceases to rise and prices rise in proportion with the money supply. This is true inflation, according to Keynes. Keynes's analysis is subjected to two main drawbacks. First, it lays emphasis on demand as the cause of inflation, and neglects the cost side of inflation. Second, it ignores the

possibility that a price rise may lead to further increase in aggregate demand which may, in term, lead to further rise in prices. However, the types of inflation during the Second World War, in the immediate post-war period, till the middle of the 1950s were on the Keynesian model based on his theory of excess demand. "In the latter 1950s, in the United States, unemployment was higher than it had been in the immediate post-war period, and yet prices still seemed to be rising, at the same time, the war time fears of postwar recession had belatedly been replaced by serious concern about, the problem of inflation. The result was a prolonged debate. . . On the one side of the debate was the 'cost-push' school of thought, which maintained that there, was no excess, demand. . . On the other side was the "demand-pull" school. . Later, in the United States, there developed a third school of thought, associate with the name of Charles Schultz, which advanced the sectoral 'demand-shift theory' of inflation. . . While the debate over cost-push versus demand-pull was raging in the United States, a new and very interesting approach to the problem of inflation and anti-inflationary policy was developed by A.W. Phillips."2 In the present chapter, we shall study all theories mentioned here, besides Keynes's theory of the inflationary gap. But before we analyse them, it is instructive to know about the meaning of inflation. MEANING OF INFLATION To the neo-classicals and their followers at the University of Chicago, inflation is fundamentally a monetary phenomenon. In the words of Friedman, "Inflation is always and everywhere a monetary phenomenon. . . and can be produced only 'by a more rapid increase in the quantity of money than output."3 But economists do not agree that money supply alone is the cause of inflation_ As pointed out by Hicks, "Our present troubles are not of a monetary character." Economists, therefore, define inflation in terms of a continuous rise in prices. Johnson defines "inflation as a sustained rise"4 in ,prices. Brooman defines it as "a continuing increase in the general price level."5 Shapiro also defines inflation in a similar vein "as a persistent and appreciable rise in the general level of prices."6 Dernberg and McDougall are more ,explicit when they write that "the term usually refers to a continuing rise in prices as measured by an index such as the consumer price index (CPI) or by the implicit price deflator for gross national product."7 However, it is essential to understand that a sustained rise in prices may be of various magnitudes. Accordingly, different types have been given to inflation depending upon the rate of rise in prices. . 1. Creeping Inflation. When the rise in prices is very slow like that of a snail Ii, or creeper, it is called creeping inflation. In terms of speed, a sustained rise in prices of animal increase of less than 3 per 'cent per annum is characterised as creeping inflation. Such an increase in prices is regarded safe and essential for economic growth. . 2. Walking or Trotting Inflation. When prices rise moderately and the annual 2

Harry G. Johnson. Essays in Monetary Economics.

3

The Counter-Revolution in Monetary Theory, 1970. Harry W. Johnson, op. cit., p.l04. 5 F.S. Brooman, op: cit., p. 285. 6 Edward Shapiro,op. cit., p. 142. 7 Macroeconomics, pp. 288. 4

inflation rate is a single digit. In other words, the rate of rise in prices is in the Intermediate range of 3 to 7 per cent per annum or less than10 per cent. Inflation lit this rate is a warning signal for the government to control it before it turns into running Inflations. . 3. Running Inflation. When prices rise rapidly like the running of a horse ,at a rate of speed of 10 to 20 per cent per annum, it is called running inflation. Such an Inflation affects the poor and middle. classes adversely Its control requires strong monetary and ,fiscal measures, otherwise it leads to hyperinflation. 4. Hyper inflation. When prices rise very fast at double or triple digit rates form more than 20 to 100, per cent per annum or more, 'lt is usually called runaway or galloping inflation. It is also characterised as hyperinflation by certain economists. In reality, hyperinflation is a situation when the rate of Inflation becomes immeasurable and absolutely uncontrollable. Prices rise many limes every day. Such a situation brings a total collapse of the monetary system because of the continuous fall in the purchasing power of money. The speed with which prices tend to rise is illustrated in Figure 31.1. The curve C shows creeping inflation when within a period of ten years the price level has been shown to have risen by about 30 per cent. The curve W depicts walking inflation when the price rose by more than 50 per cent during ten years. The curve R illustrates running inflation showing a rise of about 1OO per cent in ten years. The steep curve H shows the path of hyperinflation when prices rose by more than 120 per cent in less than one year. THE INFLATIONARY GAP In his pamphlet How, to Pay for the War published in 1940, Keynes explained the concept of the inflationary gap. It differs from his views on inflation given in the General Theory. In the General Theory, he started with underemployment equilibrium. But in How to Pay for the War, he began with a situation of full employment in the economy. He defined an inflationary gap as an excess of planned expenditure over the available output at pre-inflation or base prices. According to Lipsey, "The inflationary gap is the amount by which aggregate expenditure would exceed aggregate output at the full employment level of income." The classical economists explained inflation as mainly due to increase in the quantity of money, given the level of full employment. Keynes, on the other hand, ascribed it to the excess of expenditure over income at the full employment level. The larger the aggregate expenditure, the larger the gap and the more rapid the inflation. Given a constant average propensity to save, rising: money incomes at full employment level would lead to an excess of demand over supply and to a

consequent inflationary gap. Thus Keynes used the concept of the inflationary gap to show the main determinants that cause an inflationary rise of prices. The inflationary gap is explained with the help of the following example: Suppose the gross national product at pre-inflation prices is Rs 200 crores. Of this Rs 80 crores is spent by the Government. Thus Rs 120 (Rs 200-80) crores worth of output is available to the public for consumption at pre-inflation prices. But the gross national income at current prices at full employment level is Rs 250 crores. Suppose the government taxes away Rs 60 crores, leaving Rs 190 crores as disposable. income. Thus Rs 190 crores is the amount to be spent on the available output worth Rs 120 crores, thereby creating an inflationary gap of Rs 70 crores . This inflationary gap model is illustrated as under: 1. Gross National Income at current prices 2. Taxes 3. Disposable Income 4. GNP at pre-inflation prices

Rs 250 Cr. Rs 60 Cr. ------------Rs 190 Cr --------------Rs 200 Cr.

5. Government expenditure

Rs 80 Cr. --------------6. Output available for consumption at pre-inflation prices Rs 120 Cr. ---------------Inflationary gap (Item 3-6) = Rs 70 Cr. In reality, the entire disposable income of Rs 190 crores is not spent and a, part of it is saved. If, say, 20 per cent (Rs 38 cores) of it is saved, then Rs 152 crores (Rs 190-Rs 38 crores) would be left to create demand for goods worth Rs" 120 crores. Thus the actual inflationary gap would be Rs 32 (Rs 152-120) crores instead of Rs 70 crores. The inflationary gap is shown diagrammatically in Figure 31.2 where YF is I the full employment level of income, 45 per cent line represents aggregate supply As' and C+I+G line the desired level of consumption, investment and government expenditure (or aggregate demand curve). The economy's aggregate demand curve (C+I+G) = AD intersects the 45 per cent line (As) at point E at the income level OY1which is, greater than the full employment in come level OYF, The amount by which aggregate demand (YFA) exceeds the aggregate supply (YFB) at the full employment income level is the inflationary gap. This is AB in the figure. The excess volume of total spending when resources are fully employed creates inflationary pressures. Thus the inflationary gap leads to inflationary pressures in the economy which are .the result of excess aggregate demand.

How can the inflationary gap be wiped out? The inflationary gap can be wiped out by, increase in savings so that the aggregate demand is reduced. But this may lead to deflationary tendericies . Another solution is to raise the value of available output to match the disposable income. As aggregate demand increases, businessmen hire more labour to expand output. But there being full employment at the current money wage, they offer higher money wages to induce more workers to work for them. As there is already full employment, the increase in money wages leads to proportionate rise in prices. Moreover, output cannot be increased during the short run because factors are already fully employed. So the inflationary gap can be closed by increasing taxes and reducing expenditure. Monetary' policy can also be used to decrease the money stock. But Keynes was not in favour of monetary measures to control inflationary pressures within the economy. Its Criticisms The concept of inflationary gap has been criticised by Friedman, Koopmans, Salant, and other economists. , 1. The analysis of inflationary gap is based on the assumption that full employment prices are flexible upward. In other words, they respond to excess demand in the market for goods. It also assumes that money wages are sticky when prices are rising, but the share of profits in GNP increases. So this concept is related to excess-demand inflation' in which there is pfofit inflation. This has 8

M. Friedman, "Discussion of the Inflation of the Gap," A.E.R., Vol. 32, 1942. T. Koopmans, "The Dynamics of inflation," R.E.S., Vol. 24,1942. 10 W. Salant, "The Inflationary Gap: Meaning and Significance for Policy Making," A.E.R.. Vol. 32, 1942. 9

led to the mixing up of demand and cost inflations. 2. Bent Hansen criticised Keynes for confining the inflationary gap to the goods market only and neglecting the role of the factor market. According to him, an inflationary gap is the result of excess demand in the goods market as well as in the factor market. II 3. The inflationary gap is a static analysis. But the inflationary phenomena are dynamic. To make them dynamic, Keynes himself suggested the introduction of time lags concerning receipts and expenditures of income. Koopmans has developed relationships between eggs and the rate of price increase per unit of time. He has shown with the help of spending lags and wage-adjustment lags that the speed of inflation becomes smaller, that is the inflationary gap is narrowed.

4. Holzman has criticised Keynes for applying the multiplier technique to a full employment situation. According to him, the multiplier technique is not adequate in periods of full employment and inflation. It abstracts from changes in the distribution of income. In a full employment situation, the share of one group in the national output can only be increased at the expense of another.I2 5. Another weakness of the inflationary-gap analysis is that it is related to flow concepts, such as current income, expenditure, consumption, and saving. In fact, the increase in prices at the full employment level is not confined to prices of current goods alone. But they also affect the prices of goods already produced. Further, the disposable income which is the difference between current income and taxes, may include idle balances from the income of previous periods. Its Importance Despite these criticisms the concept of inflationary gap has proved to be of much importance in explaining rising prices at full employment level and policy measures. in controlling inflation. It tells that the rise in prices, once the level of full employment is attained, is due to excess demand generated by increased expenditures. But the output cannot be increased because al1 resources are fully employed in the economy. This leads to inflation. The larger the expenditure, the larger the gap and more rapid the inflation. As a policy measure, it suggests reduction in aggregate demand to control inflation. For this, the best course is to have a surplus budget by raising taxes. It also favours saving incentives to reduce consumption expenditure. "The analysis of the inflationary gap in terms of such aggregates as national income, investment outlays and consumption expenditures clearly reveals what determines public policy with respect to taxes, public expenditures, savings campaigns, credit control, wage adjustment-in short, an ,the conceivable antiInflationary measures affecting the propensities to consume, to save and to Invest which together determine the general price level." DIAGRAM OF INFLATIONARY GAP:

1. Give a critical assessment of anyone theory of inflation and .give reasons for selecting this particular theory.------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------2. What is inflationary-gap; Examine the usefulness of this concept in analysing a process of inflation. ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------3. Distinguish between demand-pull and cost-push inflation. How have these two views on inflation been reconciled?-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------4. "The distinction between cost-push and demand-pull inflation is unworkable, irrelevant and even meaningless." Do you agree with this view. Give reasons in support of your answer. -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------5. Discuss the theory of structural inflation. ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

POINTS TO PONDER: Inflation Inflation is a macroeconomic concept referring to an increase in the absolute price level over some defined time period. An increase in the price of all goods has the effect of reducing the purchasing power of money and money incomes and thus must be taken into account when planning future economic activity.

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CONSUMER PRICE INDEX The most common measure of inflation is that of the Consumer Price Index or 'CPI' as calculated by the Bureau of Labor Statistics (the BLS). This particular index is based on the prices of a basket of goods which represents the purchasing behavior of some average urban consumer.

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CALCULATION OF CONSUMER PRICE INDEX The CPI, also known as the Laspeyres Index, is calculated using a weighted average of current to past price ratios for this basket of goods: CPIt = Σwi,t[Pi,t / Pi,o] (1)

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Real Interest Rate Thus the Real Interest Rate represents the real return to lenders measured in terms of the purchasing power of interest paid.

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Different types of inflation Following are the different types of Inflation: Creeping inflation Walking or trotting inflation Running inflation Hyper inflation

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Inflationary Gap Meaning: "The inflationary gap is the amount by which aggregate expenditure would exceed aggregate output at the full employment level of income."

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